Simple General Equilibrium Modeling

Shantayanan Devarajan, Delfin S. Go, Jefi ey D. Lewis,

Sherman Robinson, and Pekka Sinko
I Introduction
This chapter describes how to specify, solve, and draw policy lessons
from small, two-sector, general equilibrium models of open, developing
economies.' In the last two decades, changes in the external environment
and economic policies have been instrumental in determining the perfor-
mance of these economies. The relationship between external shocks and
policy responses is complex; this chapter provides a starting point for its
analysis.
Two-sector models provide a good starting point because of the nature of
the external shocks faced by these countries and the policy responses they
elicit. These models capture the essential mechanisms by which external
shocks and economic policies ripple through the economy. By and large, the
shocks have involved the external sector: terms-of-trade shocks, such as the
fourfold increase in the price of oil in 1973-74 or the decline in primary
commodity prices in the mid-1980s; or cutbacks in foreign capital inflows.
The policy responses most commonly proposed (usually by international
agencies) have also been targeted at the external sector: (1) depreciating the
real exchange rate to adjust to an adverse terms-of-trade shock or to a
cutback in foreign borrowing and (2) reducing distortionary taxes (some of
which are trade taxes) to enhance economic efficiency and make the
economy more competitive in world markets.
A "minimalist" model that captures the shocks and policies mentioned
should therefore emphasize the external sector of the economy. Moreover,
many of the problems - and solutions - are related to the relationship
between the external sector and the rest of the economy. The model thus
1 This chapter is derived extensively from two previous papers: Devarajan, Lewis, and Robinson (1990)
and Go and Sinko (1993).
Simple ~e ne r al Equilibrium Modeling 157
should have at least two productive sectors: one producing tradable goods
and the other producing non-tradables. If an economy produces only traded
goods, concepts like real devaluation are meaningless. Such a country will
not be able to affect its international competitiveness since all of its domestic
prices are determined by world prices. If a country produced only nontraded
goods, it would have been immune to most of the shocks reverberating
around the world economy since 1973. Within the category of tradable
goods, it is also useful to distinguish importables and exports. Such a charac-
terization enables us to look at terms-of-trade shocks as well as the impact of
policy instruments such as import tariffs and export subsidies.
The minimalist model that incorporates these features, while small, cap-
tures a rich array of issues. We can examine the impact of an increase in the
price of oil (or other import andlor export prices). In addition, this model
enables us to look at the use of trade and fiscal policy instruments: export
subsidies, import tariffs, and domestic indirect taxes. The implications of
increases or decreases in foreign capital inflows can also be studied with this
framework.
While the minimalist model captures, in a stylized manner, features char-
acteristic of developing countries, it also yields policy results that cut against
the grain of received wisdom. For example, it is not always appropriate to
depreciate the real exchange rate in response to an adverse international
terms-of-trade shock; reducing import tariffs may not always stimulate ex-
ports; unifying tariff rates need not increase efficiency; and an infusion of
foreign capital does not necessarily benefit the nontradable sector (in con-
trast to the results from "Dutch disease" models).
A major advantage of small models is their simplicity. They make trans-
parent the mechanisms by which an external shock or policy change affects
the economy. In addition, the example presented in this chapter can be
solved analytically - either graphically or algebraically. It also can be solved
numerically by using the most widely available, personal computer- (PC)-
based spreadsheet programs; hence, it is not necessary to learn a new,
difficult programming language in order to get started. The presentation will
introduce the approach used to solve larger, multisector models. Finally,
these minimalist two-sector models behave in a similar fashion to more
complex multisector models, so we can anticipate some of the results ob-
tained from multisector models, such as those presented in some of the
ensuing chapters of this volume.
The plan of the chapter is as follows: In Section 11, we present the simplest
two-sector models. We specify the equations and discuss some modeling
issues. We then analyze the impact of terms-of-trade shocks and changes in
158 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko
foreign capital inflows. In Section 111, we describe an easy way of implement-
ing the framework and use it to discuss some policy issues. The conclusion,
Section IV, draws together the main points of the chapter.
II Two-Sector, Three-Good Model
The basic model refers to one country with two producing sectors and three
goods; hence, we call it the "1-2-3 model." For the time being, we ignore
factor markets. The two commodities that the country produces are (1) an
export good, E, which is sold to foreigners and is not demanded domesti-
cally, and (2) a domestic good, D, which is only sold domestically. The third
good is an import, M, which is not produced domestically. There is one
consumer who receives all income. The country is small in world markets,
facing fixed world prices for exports and imports.
The equation system is presented in Table 6.1. The model has three actors:
a producer, a household, and the rest of the world. Equation 6.1 defines the
domestic production possibility frontier, which gives the maximum achiev-
able combinations of E and D that the economy can supply. The function is
assumed to be concave and will be specified as a constant elasticity of
transformation (CET) function with transformation elasticity Q. The con-
stant xdefines aggregate production and is fixed. Since there are no interme-
diate inputs, zal so corresponds to real GDP. The assumption that z i s fixed
is equivalent to assuming full employment of all primary factor inputs.
Equation (6.4) gives the efficient ratio of exports to domestic output (EID) as
a function of relative prices. Equation (6.9) defines the price of the composite
commodity and is the cost-function dual to the first-order condition, equation
(6.4). The composite good price Px corresponds to the GDP deflator.
Equation (6.2) defines a composite commodity made up of D and M which
is consumed by the single consumer. In multisector models, we extend this
treatment to many sectors, assuming that imports and domestic goods in the
same sector are imperfect substitutes, an approach which has come to be
called the Armington ass~mption.~ Following this treatment, we assume the
composite commodity is given by a constant elasticity of substitution (CES)
aggregation function of M and D, with substitution elasticity o. Consumers
maximize utility, which is equivalent to maximizing Q in this model, and
equation (6.5) gives the desired ratio of M to D as a function of relative
price^.^ Equation (6.10) defines the price of the composite commodity. It is
2 See Armington (1969).
3 In the multisector models, we add expenditure functions with many goods based on utility
maximization at two levels. First, allocate expenditure among goods. Second, decide on sectoral import
ratios. In the 1-2-3 model, the CES hnction defining Q can be treated as a utility hnction directly.
1 Simple General Equilibrium Modeling
159
!
Table 6.1. The basic 1-2-3 CGE model
I E!!us
Prices
i
(6.1) X = G(E, DS; n)
(6.7) P" = R pw"
I I
(6.2) QS - F(M, DD; a)
(6.8) PC = R . pwC
I (6.6) Y = px.X + R . E Eauilibrium Conditions
Endoeenous Variable
E: Export good
P': Price of aggregate output
M: Import good
P: Price of composite good
DS: Supply of domestic good R: Exchange rate
DD: Demand for domestic good
Q: Supply of composite good
Exoeenous Variables
QD: Demand for composite good
pw': World price of export good
Y: Total income pw": World price of import good
P". Domestic price of export good
8: Balance of trade
Pm: Domestic price of import good
o: Import substitution elasticity
Pd: Domestic price of domestic good
!I: Export transformation elasticity
the cost-function dual to the first-order conditions underlying equation (6.5).
The price P4 corresponds to an aggregate consumer price or cost-of-living
index.
Equation (6.6) determines household income. Equation (6.3) defines
household demand for the composite good. Note that all income is spent on
the single composite good. Equation (6.3) stands in for the more complex
system of expenditure equations found in multisector models and reflects an
160 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinron, P. Sinko Simple General Equilibrium Modeling
161
important property of all complete expenditure systems: The value of the
goods demanded must equal aggregate expenditure.
In Table 6.1, the price equations define relationships among seven prices.
There are fixed world prices for E and M, domestic prices for E and M, the
price of the domestic good D; and prices for the two composite commodities,
X and Q. Equations (6.1) and (6.2) are linearly homogeneous, as are the
corresponding dual price equations, (6.9) and (6.10). Equations (6.3) to (6.5)
are homogeneous of degree zero in prices - doubling all prices, for example,
leaves real demand and the desired export and import ratios ~nchanged. ~
Since only relative prices matter, it is necessary to define a numkraire price;
in equation (6.11), this is specified to be the exchange rate R.
Equations (6.12), (6.13), and (6.14) define the market-clearing equilib-
rium conditions. Supply must equal demand for D and Q, and the balance of
trade constraint must be satisfied. The complete model has fourteen equa-
tions and thirteen endogenous variables. The three equilibrium conditions,
however, are not all independent. Any one of them can be dropped and the
resulting model is fully determined.
To prove that the three equilibrium conditions are not independent, it
suffices to show that the model satisfies Walras's Law. Such a model is
"closed" in that there are no leakages of funds into or out of the economy.
First note the three identities - (6.15), (6.16), and (6.17) - that the model
satisfies. The first two arise from the homogeneity assumptions and the third
from the fact that, in any system of expenditure equations, the value of
purchases must equal total expenditure.' Multiplying equations (6.12) and
(6.13) by their respective prices, the sum of equations (6.12), (6.13), and
(6.14) equals zero as an identity (moving Bi n equation [6.14] to the left
side). Given these identities, simple substitution will show that if equations
(6.12) and (6.13) hold, then so must (6.14).
The 1-2-3 model is different from the standard neoclassical trade model
with all goods tradable and all tradables perfect substitutes with domestic
goods. The standard model, long a staple of trade theory, yields wildly
implausible results in empirical app~ications.~ Empirical models that reflect
these assumptions embody "the law of one price," which states that domestic
relative prices of tradables are set by world prices. Such models tend to yield
4 For the demand equation, one must show that nominal income doubles when all prices double,
including the exchange rate. Tracing the elements in equation (6.6), it is easy to demonstrate that
nominal income goes up proportionately with prices.
5 In this model equation (6.3) and identity (6.17) are the same. In a multisector model, as noted, identity
(iii) i! a necessary property of any system of expenditure equations.
6 Emp~rical problems with this specification have been a thorn in the side of modelers since the early
days of linear programming models. For a survey, see Taylor (1975).
extreme specialization in production and unrealistic swings in domestic rela-
tive prices in response to changes in trade policy or world prices. Empirical
evidence indicates that changes in the prices of imports and exports are only
partially transmitted to the prices of domestic goods. In addition, such
models cannot exhibit two-way trade in any sector ("cross-hauling"), which
is often observed at fine levels of disaggregation.
Recognizing these problems, Salter (1959) and Swan (1960) specified a
two-sector model distinguishing "tradables" (including both imports and
exports) and "nontradables." Their approach represented an advance and
the papers started an active theoretical literature. However, they had little
impact on empirical work. Even in an input-output table with over five
hundred sectors, there are very few sectors which are purely non-traded; i.e.,
with no exports or imports. So defined, non-traded goods are a very small
share of GDP; and, in models with ten to thirty sectors, there would be at
most only one or two non-traded sectors. Furthermore, the link between
domestic and world prices in the Salter-Swan model does not depend on the
trade share, only on whether or not the sector is tradable. If a good is
tradable, regardless of how small is the trade share, the domestic price will
be set by the world price.
The picture is quite different in the 1-2-3 model with imperfect sub-
stitutability and transformability. All domestically produced goods that
are not exported (D in Table 6.1) are effectively treated as non-tradables
(or, better, as "semi-tradables"). The share of non-tradables in GDP now
equals 1 minus the export share, which is a very large number, and all
sectors are treated symmetrically. In effect, the specification in the 1-2-3
model extends and generalizes the Salter-Swan model, making it empirically
relevant.
De Melo and Robinson (1985) show, in a partial equilibrium framework,
that the link between domestic and world prices, assuming imperfect substi-
tutability at the sectoral level, depends critically on the trade shares, for both
exports and imports, as well as on elasticity values. For given substitution
and transformation elasticities, the domestic price is more closely linked to
the world price in a given sector the greater are export and import shares. In
multisector models, the effect of this specification is a realistic insulation of
the domestic price system from changes in world prices. The links are there,
but they are not nearly as strong as in the standard neoclassical trade model.
Also, the model naturally accommodates two-way trade, since exports, im-
ports, and domestic goods in the same sector are all distinct.
Given that each sector has seven associated prices, the model provides for
a lot of product differentiation. The assumption of imperfect substitutability
162 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko Simple General Equilibrium Modeling 163
on the import side has been widely used in empirical models.' Note that it is
equally important to specify imperfect transformability on the export side.
Without imperfect transformability, the law of one price would still hold for
all sectors with exports. In the 1-2-3 model, both import demand and export
supply depend on relative prices.'
De Melo and Robinson (1989) analyze the properties of this model in
some detail and argue that it is a good stylization of most recent single-
country, trade-focused, computable general equilibrium (CGE) models.
Product differentiation on both the import and export sides is very appealing
for applied models, especially at the levels of aggregation typically used. The
specification is a faithful extension of the Salter-Swan model and gives rise
to normally shaped offer curves. The exchange rate is a well-defined relative
price. If the domestic good is chosen as the numCraire commodity, setting pd
equal to 1, then the exchange rate variable R corresponds to the real ex-
change rate of neoclassical trade theory: the relative price of tradables ( E
and M) to non-tradables (D). Trade theory models (and our characteriza-
tion in Table 6.1) often set R to 1, with pd then defining the real exchange
rate. For other choices of numhaire, R is a monotonic function of the real
exchange rate.g
The 1-2-3 model can also be seen as a simple programming model. This
formulation is given in Table 6.2 and is shown graphically in Figure 6.1. The
presentation emphasizes the fact that a single-consumer general equilibrium
model can be represented by a programming model that maximizes con-
sumer utility, which is equivalent to social welfare.'' In this model, the
shadow prices of the constraint equations correspond to market prices in the
CGE model." We will use the graphical apparatus to analyze the impact of
7 The CES fonnulation for the import-aggregation function has been criticized on econometric grounds
(see Alston et al., 1990, for an example). It is certainly a restrictive form. For example, it constrains
the income elasticity of demand for imports to be one in every sector. Rathei than completely
rejecting approaches that rely on imperfect substitutability, this criticism would seem to suggest that
it is time to explore the many alternative functional forms that are available. For example, Hanson,
Robinson, and Tokarick (1993) estimate sectoral import demand functions based on the almost ideal
demand system (AIDS) formulation. They find that sectoral expenditure elasticities of import de-
mand are generally much greater than one in the United States, results consistent with estimates from
macroeconometric models. Factors other than relative prices appear to affect trade shares, and it is
important to study what they might be and how they operate. Alston and Green (1990) also estimated
the AIDS import formulation. A related paper is Shiells, Roland-Holst, and Reinert (1993).
8 Dervis, de Melo, and Robinson (1982) specify a logistic export supply function in place of equation
(6.4) in Table 6.1. Their logistic function is locally equivalent to the function that is derived from the
CET specification.
9 Dervis, de Melo, and Robinson (1982). Chapter 6, discuss this relationship in detail.
10 Ginsburgh and Waelbroeck (1981) discuss, in detail, the general case where a multiconsumer CGE
model can be represented by a programming model maximizing a Negishi social welfare function. See
also Ginsburgh and Robinson (1984) for a brief survey of the technique applied to CGE models.
11 In the programming model, we implicitly choose Q as the numkraire good, with Pq=l . In the
graphical analysis, we set Rs 1.
Table 6.2. The 1-2-3 model as a programming problem
Maximize Q = F(M, DD; a) (absorption)
with respect to: M, E, DD, Ds
subject to: Shadow Price
(6.18) G(E, D~; n) 4 jZ (technology) A' = P'IP'
(6.19) pwm M < pw'. E + (balance of trade) Ab = RI P
(6.20) DD L (domestic supply and demand)
Ad = PIPI
where Constraints 6.18 to 6.20 correspond to Equations 6.1, 6.14, and 6.12 in Table 6.1.
!
two shocks: an increase in foreign capital inflow and a change in the interna-
tional terms of trade.'* We will also use this programming-model formula-
tion, including endogenous prices and tax instruments, to derive optimal
policy rules under second-best conditions.
The transformation function (equation [6.1] in Table 6.1 and constraint
16.181 in Table 6.2) can be depicted in the fourth (southeast) quadrant of the
four-quadrant diagram in Figure 6.1. For any given price ratio PdIPe, the
point of tangency with the transformation frontier determines the amounts
of the domestic and exported good that are produced. Assume, for the
moment, that foreign capital inflow is zero. Then, constraint 6.19, the
balance-of-trade constraint, is a straight line through the origin, as depicted
in the first quadrant of Figure 6.1. If we assume for convenience that all
world prices are equal to 1, then the slope of the line is 1. For a given level
of E produced, the balance-of-trade constraint determines how much of the
imported good the country can buy. Intuitively, with no capital inflows
(E=o), the only source of foreign exchange is exports. The second quadrant
shows the "consumption possibility frontier," which represents the combina-
tions of the domestic and imported goods that the consumer can buy, given
the production technology as reflected in the transformation frontier and the
balance of trade constraint. When world prices are equal and trade is bal-
anced, the consumption possibility frontier is the mirror image of the trans-
formation frontier. Equation (6.2) in Table 6.1 defines "absorption," which
12 The discussion follows de Melo and Robinson (1989).
164 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko
I M 1
Simple General Equilibrium Modeling 165
I
Figure 6.1. The 1-2-3 programming model
I
Figure 6.2. Increase in foreign capital inflow
is maximized in the programming problem. The tangency between the "iso-
absorption" (or indifference) curves and the consumption possibility
frontier will determine the amount of D and M the consumer will demand,
at price ratio Pd/Pm. The economy produces at point P and consumes at
point C.
Now consider what would happen if foreign capital inflow increased from
its initial level of zero to some value (B>o). For example, the country gains
additional access to world capital markets or receives some foreign aid.
Alternatively, there is a primary resource boom in a country where the
resource is effectively an enclave, so that the only direct effect is the repa-
triation of export earnings." In all of these cases, we would expect domestic
prices to rise relative to world prices and the tradable sector to contract
relative to the non-tradable sector. In short, the country would contract
"Dutch disease." That this is indeed the case can be seen by examining
Figure 6.2. The direct effect is to shift the balance of trade line up by This
13 See Benjamin and Devarajan (1985) or Benjamin, Devarajan, and Weiner (1989).
shift, in turn, will shift the consumption possibility frontier up verticaUy by
the same B The new equilibrium point will depend on the nature of the
import aggregation function (the consumer's utility function). In Figure 6.2,
the consumption point moves from C to C*, with increased demand for both
D and M and an increase in the price of the domestic good, pd. On the
production side, the relative price has shifted in favor of the domestic good
and against the export - an appreciation of the real exchange rate.
Will the real exchange rate always appreciate? Consider two polar ex-
tremes, which bracket the range of possible equilibria. Suppose the elasticity
of substitution between imports and domestic goods is nearly infinite, so that
the indifference curves are almost flat. In this case, the new equilibrium will
lie directly above the initial one (point C), since the two consumption
possibility curves are vertically parallel. The amount of D consumed will
not change and all the extra foreign exchange will go toward purchasing
impom. By contrast, suppose the elasticity of substitution between M and
D is zero, so the indifference curves are L-shaped. In this case (assuming
166 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko Simple General Equilibrium Modeling
167
homotheticity of the utility function), the new equilibrium will lie on a ray
radiating from the origin and going through the initial equilibrium. In this
new equilibrium, there is more of both D and M consumed, and the price
ratio has risen. Since Pm is fixed by hypothesis, Pd must have increased - a
real appreciation. The two cases bound the range of possible outcomes. The
real exchange rate will appreciate or, in the extreme case, stay unchanged.
Production of D will either remain constant or rise and production of E, the
tradable good in this economy, will either stay constant or decline. The
range of intermediate possibilities describes the standard view of the Dutch
disease.
Consider now an adverse terms-of-trade shock represented by an increase
in the world price of the imported good. The results are shown in Figure 6.3.
The direct effect is to move the balance of trade line, although this time it is
a clockwise rotation rather than a translation (we assume that initially E=o).
For the same amount of exports, the country can now buy fewer imports.
The consumption possibility frontier is also rotated inward. The new con-
sumption point is shown at C*, with less consumption of both imports and
domestic goods. On the production side, the new equilibrium is P*. Exports
have increased in order to generate foreign exchange to pay for more expen-
sive imports, and peIpd has also increased to attract resources away for D
and into E. There has been a real depreciation of the exchange rate.
Will there always be a real depreciation when there is an adverse shock
in the international terms of trade? Not necessarily. The characteristics of
the new equilibrium depend crucially on the value of o, the elasticity of
substitution between imports and domestic goods in the import aggregation
function.
Consider the extremes of a=O and o==. In the first case, as in Figure
6.3, there will be a reduction in the amount of domestic good produced
(and consumed) and a depreciation of the real exchange rate. In the
second case, however, flat indifference curves will have to be tangent to
the new consumption possibility frontier to the left of the old consumption
point (C), since the rotation flattened the curve. At the new point, output of
D rises and the real exchange rate appreciates. When o=l, there is no
change in either the real exchange rate or the production structure of the
economy. The intuition behind this somewhat unusual result is as follow^:'^
When the price of imports rises in an economy, there are two effects: an
income effect (as the consumer's real income is now lower) and a substitu-
tion effect (as domestic goods now become more attractive). The resulting
Figure 6.3. Change in world prices
equilibrium will depend on which effect dominates. When o<l, the income
effect dominates. The economy contracts output of the domestic good and
expands that of the export commodity. In order to pay for the needed, non-
substitutable import, the real exchange rate depreciates. However, when
m l , the substitution effect dominates. The response of the economy is to
contract exports (and hence also imports) and produce more of the domestic
substitute.
For most developing countries, it is likely that o<l , so that the standard
policy advice to depreciate the real exchange rate in the wake of an adverse
terms-of-trade shock is correct. For developed economies. one might well
expect substitution elasticities to be high. In this case, the responses to a
terms-of-trade shock are a real revaluation, substitution of domestic goods
for the more expensive (and non-critical) import, and a contraction in the
aggregate volume of trade. In all countries, one would expect substitution
elasticities to be higher in the long run. The long-run effect of the real
exchange rate will thus differ, and may be of opposite sign, from the short-
14 We derive the result analytically later.
run effect.
,
168 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko Simple General Equilibrium Modeling 169
The relationship between the response of the economy to the terms-of-
I
trade shock and the elasticity of substitution can also be seen by solving the ,
model algebraically. By considering only small changes to the initial equilib- I
rium, we can linearize the model and obtain approximate analytical solu-
;
tions. We follow this procedure to analyze the impact of a terms-of-trade
shock.''
Let a "^" above a variable denote its log-differential. That is, i=d(ln
i
1
z)=dz/z. Log-differentiate equations (6.4), (6.5), and (6.14) in Table
!
6.1, assuming an exogenous change in the world price of the import. The
,
results are
i
~ + j w ' " = k
Eliminating M, 6, and l? and solving for Sd yields
Thus, whether pd increases or decreases in response to a terms-of-trade
shock depends on the sign of (0-1), confirming the graphical analysis dis-
cussed. Figure 6.4 illustrates the impact of a 10 percent import price shock on
Pd under varying trade elasticities, 0<0<2 and OcR<2. Note that the direc-
tion of change in pd will determine how the rest of the economy will adjust
in this counterfactual experiment. If pd falls (the real exchange rate depre-
ciates), exports will rise and production of the domestic good will fall.
Our analysis with the 1-2-3 model has yielded several lessons. First, the
bare bones of multisector general equilibrium models are contained in this
small model. Second, and perhaps more surprisingly, this two-sector model
is able to shed light on some issues of direct concern to developing countries.
For example, the appreciation of the real exchange rate from a foreign
capital i dow, widely understood intuitively and derived from more complex
models, can be portrayed in this simple model. In addition, results from this
small model challenge a standard policy dictum: Always depreciate the real
exchange rate when there is an adverse terms-of-trade shock. The model
15 De Melo and Robinson (1989) derive the closed-form solution for the country's offer curve in the 1-
2-3 model. A more complete discussion and mathematical derivation are given in Devarajan, Lewis,
and Robinson (1993).
Figure 6.4. Import price shock, trade elasticities, and domestic prices
I
shows the conditions under which this policy advice should and should not
be followed.
Of course, many aspects of the economy are left out of the small model.
In particular, there are no government, factor markets, and intermediate
goods; the framework is also static. Devarajan, Lewis, and Robinson
(1990) discuss several extensions and modeling issues in a one-period set-
ting; Devarajan and Go (1993) present a dynamic version of the 1-2-3
framework in which producer and consumer decisions are both intra- and
intertemporally consistent. All these extensions require that the model be
solved numerically. We turn therefore to the numerical implementation of
the 1-2-3 model, extending the basic 1-2-3 model to include the govern-
ment sector in order to look at policy instruments such as taxes.
III Numerical Implementation
As a means of evaluating economic policy or external shocks, general equi-
librium analysis has several known advantages over the partial approach and
its numerical implementation has become increasingly the preferred tool of
investigation.16 So far, however, CGE models are cumbersome to build,
16 Robinson (1989) contains a survey of CGE applications to developing countries.
170 S. Devarajan, D.S. Go, J.D. Lewk, S. Robinson, P. Sinko Simple General Equilibrium Modeling 171
requiring extensive data, model calibration, and the learning of a new and
often difficult programming language. For that reason, the partial approach
still dominates practical applications because of its simplicity. In the field of
public finance, for example, it is a relatively simple affair for non-specialists
to deal with tax ratios, the projections of collection rates of taxes and their
corresponding bases, and, if necessary, to augment the analysis with estirna-
tions of tax elasticities.I7 Moreover, since only ratios of taxes to GDP are
used, the partial approach has the further advantage of requiring the least
information and offering a quick way of looking at the revenue significance
of taxes. Nevertheless, using fixed ratios and assuming zero elasticities ig-
nore the feedback into other markets and the division of the tax burden; it
limits the investigation and leads to an incomplete picture. General equilib-
rium analysis avoids these limitations, but the problem has been to find an
easy and convenient way of doing it.
Fortunately, the simplicity of the 1-2-3 model and the availability of
more powerful Windows-based spreadsheet tools for the desktop PC, like
Microsoft Excel for Windows (Excel hereafter),'' provide appealing and
tempting alternatives for CGE modeling. These tools have built-in graphics,
easy integration with other Windows applications, and convenient access.to
interesting add-in programs. Being much easier to learn and use, they make
CGE analysis more accessible to economists who are otherwise discouraged
by unwieldy programming. A model based on a popular spreadsheet pro-
gram can also become an effective vehicle for illustrative and educational
purposes. While Excel is one example and hardly the only software suitable
for economic modeling, the robustness and flexibility of its solver function,
which is quite capable of finding numerical solutions of systems of linear and
non-linear equations and inequalities, as well as its user-friendliness and
wide distribution make it a particularly attractive tool for potential CGE
modelers.
In what follows, we describe a stepwise procedure to implement the 1-2-
3 model using ~xce1. l ~ We also run a few policy simulations by applying the
model to one small open economy, Sri Lanka.
III.1 The 1-2-3 Model with Government and Investment
In the previous section, the discussion of the 1-2-3 model focused on the
relative price of traded goods relative to the price of domestic goods and
17 See Prest (1962) and Chelliah and Chand (1974) for a discussion of such an approach.
18 Microsofr Excel and Windows are trademarks of Microsoft Corporation.
19 The discussion of Excel procedures is compatible with version 5 or later, such as version 5 under
Windows 3.1 or version 7 under Windows 95. We also include in the notes, where applicable, how to
implement the same procedures in the previous version of Excel.
how this real exchange rate adjusts in response to exogenous shocks.
In order to apply the framework to a particular country, however, it has
to be modified to fit real data and to handle policy issues. For example,
the real exchange rate is not an instrument, which the government directly
controls. Rather, most governments use taxes and subsidies as well as
expenditure policy to adjust their economies. Nor did the previous
section touch on the equality of savings and investment, which is important
in bringing about macroeconomic balance or equilibrium. Table 6.3 presents
an extended version of the 1-2-3 model to include government revenue
and expenditure and also savings and investment. We make sure that the
modifications introduced will conform to data that are commonly available
(see calibration later). In the new setup, four tax instruments are included:
an import tariff tm, an export subsidy re, an indirect tax on domestic sales ts,
and a direct tax rate tY. In addition, savings and investment are included.
The single household saves a fixed fraction of its income. Public savings,
(budgetary deficit or surplus) is the balance of tax revenue plus foreign
grants and government expenditures (all exogenous) such as government
consumption and transfers to households. The current account balance,
taken to represent foreign savings, is the residual of imports less exports
at world prices, adjusted for grants and remittances from abroad. Output
is fixed for reasons cited in Section 11. Foreign savings is also presently
fixed, so that the model is savings-driven; aggregate investment adjusts
to aggregate savings.20 In sum, we have twenty equations and nineteen
endogenous variables. By Walras's Law, however, one of the equations, say
the savings-investment identity, is implied by the others and may be
dropped.
111.2 Defining Model Components
Building the 1-2-3 framework in Excel requires the usual modeling
steps: (1) declaration of parameters and variables, (2) data entry, (3) assign-
ment of initial values to variables and parameters, and (4) specification
of equations. In addition, the model has to be precisely defined as a
collection of equations; in some cases, it may require an objective function
to be optimized. Finally, the solver is called on to conduct numerical
simulations.
A suitable way to arrange the 1-2-3 model in an Excel worksheet is to
assign separate columns or blocks for parameters, variables, and equations.
20 In the alternative investment-driven closure, aggregate investment is fixed and savings adjust through
foreign savings (endogenous). For a discussion of alternative macroclosures, see the original work of
Sen (1963) or the surveys by Rattso (1982) and Robinson (1989).
S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko Simple General Equilibrium Modeling 173
Table 6.3. The 1-2-3 model with government and investment
Real Flows
(6.21) X = G(E,DS;n) (6.30) Pm = (1 + P') R . pwm
(6..22) Q5 = F(M,DD;a) (6.31) P = (1 + P).R.pwa
(6.23) QD = C + Z + 6
(6.32) P = (1 + P).Pq
(6.24) E/DS = g, p, m (6.33) P' = g, p, Pd)
(6.25) M/DD = f,(P",P?
(6.34) P = f,(Pm,P)
Nominal Flows
(6.35) R = 1
(6.26) T = t "- R- pW- M
ai l i hr i um Conditions
+ P. F. QD (6.36) DD - DS = 0
+ tY.Y (6.37) QD - QS = 0
- r.R.pw' .E (6. 38)pwm. M-pw". E-ft-re =
(6.27) Y = P'.? + t r - P + re-R (6.39) PL.Z - S = 0
(6.28) S =b. Y + R. B+ Ss
( 6 . 4 0 ) ~ - P . G - t r . P - f t - ~ - ~ s = 0
(6.29) C - P = (I - S- t q- Y
Accountine Identitie
(6.41) P'.? - P - E + P. DS
(6.42) P. QS = Pm.M + P. DD
,Endo-enous Variable: Exoeenous Variables:
E: Export good
pwm: World price of import good
M: Import good
pw': World price of export good
DS: Supply of domestic good tm: Tariff rate
Do: Demand for domestic good
P: Export subsidy rate
Qs: Supply of composite good P: saleslexciselvalue-added tax rate
QD: Demand for composite good ty: direct tax rate
P: Domestic price of export good
tr: government transfers
Pm: Domestic price of import good
ft: foreign transfers to government
P: Producer price of domestic good
re: foreign remittances to private sector
P': Sales price of composite good
-
s: Average savings rate
Pt: Price of aggregate output
" Aggregate output
P: Price of composite good
G: Real government demand
R: Exchange rate
B: Balance of trade
T: Tax revenue
R: Export transformation elasticity
Ss: Government savings
a: Import suhstitution elasticity
Y: Total income
C: Aggregate consumption
S: Aggregate savings
Z: Aggregate real investment
Separate columns are assigned for the base year and simulation values of
variables. Labels and explanations for parameters, variables, and equations
are easily provided in 'the adjacent left column to improve readability. We
also assign a block for the dataset with both initial and calibrated values
displayed. Thus, we are able to arrange all necessary ingredients conven-
iently on a single worksheet.
111.3 Variables and Parameters
Table 6.4 is an example of how to organize the parameters and variables in
an Excel-based model. We separate out from the rest of the exogenous
variables the parameters related to the trade elasticities; the trade elasticities
are generally defined at the outset of an experiment, and parameters such as
the share and scale values of the CES and CET functions are calibrated just
once for both the base case and the current simulation (see the calibration
section later). Column A provides a brief description of each parameter and
column B lists the corresponding numerical value. The exogenous variables
(described in column C) specify the external or policy shocks introduced in
a particular experiment - their magnitudes are defined in column E while
their base-year values are presented in column D. Likewise, the endogenous
variables are listed in columns F to I. New values are computed for the
endogenous variables during a simulation and entered in column H as
Current. Column I, CurlBase, provides simple indices of change of the
endogenous variables.
A useful feature in Excel is the capability to define names for various
model parts. This is done by using the Name command and Define option
under the Insert menu.21 The cell in 8 6 of Table 6.4, for example, can be
called by its parameter name, st; hence, we can refer to parameters, vari-
ables, or equations by using their defined or algebraic names instead of cell
locations. By doing this, we make the model specifications easier to read and
mistakes easier to detect. To keep track of these names, it is advisable to
write them out in explanation cells adjacent to the corresponding param-
eters, variables, and equations. In the example shown in Table 6.4, we write
a short description and put in parentheses the Excel label or name. Base
year and current values of variables are distinguished by using the normal
convention - in the case of export good E, for example, the base year level
is labeled as EOwhile E is retained for the simulated level.
21 Prior to version 5 of Excel, this is done by using the Define Name command in the Formula
menu.
'C]
9
a
w
E
.9
-
0"
w
C,
c
k
-0
2'
.-
- -
3
a
X
s
z
- .-
w
e
X
- .-
1
e , .
2 2
m .o
g 3
.-
z 3
5 -
E.2
04
9 0
- z
- -
2 2'
? 2
o m
'O c
g 3
.-
5 5
' k
&
.* d
L. .J
m v
w e ,
e 3
l r0
N N
176 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko
Table 6.5. List of equations in the Excel-based 1-2-3 model
L I J ! K 1 L 1
-
6
7
8
9
10
17 6.30 lmpon Price Equation IPMEQl =Er'wm'll +tm)
18 6.31 Expon Price Equation (PEE01 = Er'welll + tel
19 6.32 Sales Price Eouation IPTEQI
11
12
13
14
15
16
6.21
6.22
6.23
6.24
6.25
1 26 1 6.38 kurrent Account Balance [CABAL) I =wm0M - we'E -ft - re I
6.26
6.27
6.28
6.29
23
24
25
1 27 16.39 IGovernment Bud~et IGBUD) I = Tax - G'Pt - tr*Pa + ft'Er I
. . . - . . -
CET Transformation (CETEO)
Supply of Goods (ARMG)
Domestic Demand IDEM1
EID Ratio (EDRAT)
MID Ratio (MDRAT)
The dual price equations, equations (6.33) (PXEQ) and (6.34) (PQEQ), can
take the following form:
=at*(bt'EA(nl + l l - b t ) * D~ ~ ( n I ) ~ I l In)
=aq.(bq.MA(-rq) + (1 -bq)*DdaI-rqllA(-1 lrq)
-Cn+Z+G
-1 (PelPdlllbtlll -btll lAlll(rt-1))
=I (PdlPml'(bql(1-bql) l ^ ( l l l l +rq)l
Nominal Rows
Revenue Equation (TAXEO)
Total Income Equation (lNC1
Savings Equation ISAV)
Consumption Function ICONS)
Prices
6.36
6.37
However, in practice, it is often convenient to replace the dual price equa-
tions with the expenditure identities, invoking Euler's theorem for linearly
homogeneous functions:
= trnewm'Er*M + te.Pe*E + n'Pq'Od + ty'Y
= Px'X+ tr'Pq + re'Er
-syeY +ErSB+Sg
=YaI1-ty-syl1Pt
In the 1-2-3 model, the dual price equations embody the same information
as the CET export transformation and CES import aggregation functions. In
Equilibrium Conditions
Domestic Good Market (DEQ)
Composite Good Market (ClEOl
Simple General Equilibrium Modeling 177
-Dd - Ds
=Od -0s
Table 6.6. Data in the Excel-based 1-2-3 model
[ MI N I Cl I I ' l a ( R l s l T
I I I I I
68.16 0.21
25 External Debt 260.50 0.80
26 Debt Service Payments 20.21 0.06
"9
some applications, it is convenient to include the dual price equations, but
drop the CET and CES functions.
111.5 Calibration
Another convenient feature of the 1-2-3 framework is its modest data
requirements. Data from national income, fiscal, and balance-of-payments
accounts, those normally released by national governments, are sufficient.
To cany out the model, we used the 1991 data for Sri Lanka (Table 6.6). The
original data were measured in billions of rupees. In the calibration, all data
were scaled and indexed with respect to output, which is set to 1.00 in the
base year (note columns P and T).
Tables 6.7 and 6.8 show the calibration of parameters and variables. The
values of the parameters and variables are linked to the data in Table 6.6 so
that model calibration is automatically done whenever the elasticities or
base year data are changed. In Table 6.7, the calibration of the exponents, rt
Table 6.8. Calibration of variables in the Excel-based 1-2-3 model
27
28
29
Government Savings IS01
Walres Law 12-Sl
= Tax0 . GO.PtO - trOaPqO + ftO'ErO
=ZO'PtO- SO
180
S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko Simple General Equilibrium Modeling 181
Figure 6.5. Excel's solver
solves the model as an optimization or programming problem. In the Set
Target Cell space, at the top of the dialog box, the name of the variable that
is being maximized (max option) or minimized (min option) in the objective
function may be entered. We select the consumption variable CN in this
case, but this has no effect in a CGE application since there will be as many
variables and equations. The space may also be left empty. The "optimal"
solution is found By Changing Cells, where all the endogenous variables in
the model are entered using their names or cell locations, and Subject to the
Constraints, where all equations and non-negativity constraints of the model
are listed. The Add option in the dialog box allows us to specify the equa-
tions and constraints one at a time. For example, the line highlighted in
Figure 6.5 matches the mathematical expression of the Armington function
to total supply (ARMG=Q), which corresponds to the first equation of our
model when arranged alphabetically.
The Options command in the Solver Parameters menu controls the solu-
tion process. The Options command lets one adjust the maximum iteration
time and tolerance level as well as choose the appropriate search method. In
the model, we used the Newton solution algorithm, which proved out to be
robust and fast. Average time for solving simulations with a 486133 PC was
around 10 seconds.
The model is run by choosing the Solve command. The solver starts
iterating and the number of trial solutions appears in the lower-left part of
the worksheet. Once a solution that satisfies all the constraints has been
found, the Solver stops and displays a dialog box to show the results. A
variety of ways for reporting the outputs are possible. One can now choose
between displaying the solution values on the worksheet and restoring the
original values (initial guesses) of variables. Also, one may choose the
option that produces both the original values and solution values. If there is
no shock and the model is correctly calibrated, one should find a solution
where all the variables equal their base-year values within the fixed toler-
a n ~ e . ~ ~ For example, 0.33, the base-year value of EO(export good) in cell G6
in Table 6.4, is entered as the initial guess or current value for the variable
E in cell H6. It is important to enter some feasible initial guesses for current
values of variables before starting the solver. An empty cell is interpreted as
zero, which is frequently an infeasible value for a variable.
111.7 Simulations
To test the model, we conduct two experiments. The first is a trivial case -we
double the nominal exchange rate, which is our numCraire. This is done by
changing the right-hand side of equation 6.35 from 1.0 to 2.0 as shown in cell
L22 in Table 6.5. After the experiment is run, the results are shown as the
current values of the variables in column H of Table 6.4. As expected, all
prices and incomes double while all quantities remain the same.
Next, we look at one important tax policy issue in developing countries -
the fiscalhevenue implications of a tariff reform. Tariffs are a significant
source of public revenue in many developing countries. In Sri Lanka, about
28 percent of tax revenue came from import duties in 1991. Therefore, the
potential revenue losses of a tariff reduction in any attempted trade liberali-
zation has to be offset by other revenue sources so as to prevent the balance
of external payments from det eri ~rat i ng. ~ In the experiment, we set the
tariff collection rate to 0.05 (down from 0.13 in the base year) and ask by
how much the domestic indirect taxes need to be raised to maintain the
current account deficit from deteriorating, while keeping the same level of
productive investment in the economy. To do this, we simply replace invest-
ment Z with the sales tax ts in the variable list and run the 1-2-3e model
again. To attain the preceding policy objective, we find that sales and excise
taxes need to be raised by about 33 percent (from the current rate of 0.08 to
26 A good a way of testing the model is to maximize and minimize the objective variable, which should
produce identical solutions in a general equilibrium framework.
27 Greenaway and Milner (1991) and Mitra (1992) discuss the substitution of the domestic and trade
taxes in greater detail.
182 S. Devarajan, D.S. Go, J.D. Lewis, S. Robinson, P. Sinko
Simple General Equilibrium Modeling 183
Table 6.9. Coordinated tariff and tax reform
I F G H I 1
--
3 1 I
4 l~ndogenous Variables I Base Year I Current 1 CurEase
6 1 I I I
6 l ~x pon Gwd (El 1 0.33 1 0.33 1 1.02
7 l~rnoon ~ o o d (MI 1 0.50 1 0.51 I 1.01
.-
I I I
13 l ~ a x Revenue FAX) 1 0.20 1 0.19 1 0.95
8
9
10
11
17
14 ITotal Income IY) 1 1.13 1 0.10 1 0.97
15 l~ggregate Savings IS) 1 0.27 1 0.26 1 0.98
16 I~onsumotion fCnl 1 0.83 1 0.83 1 1.00
0.11 in cells G25 and H25, respectively, in Table 6.9). This figure of course
depends on, among other factors, the degree of substitution possibilities :
between imports and domestic goods. Because of the "automatic" calibra-
tion embedded in the worksheet, it would be straightforward to test t he !
sensitivity of the results on alternate values of critical parameters by jusl
entering new estimates to the corresponding cells.
Supply of Domestic Good IDS)
Demand of Dornestlc Good (Ddl
Supply of Composne Good (0s)
Demand of Cornposlte Good (ad1
IV Conclusion
This chapter shows how two-sector models can be used to derive policy
lessons about adjustment in developing countries. Starting from a small,
one-country, two-sector, three-good (1-2-3) model, we show how the effects
of a foreign capital inflow and terms-of-trade shock may be analyzed. In
particular, we derive the assumptions underlying the conventional policy
recommendation of exchange rate depreciation in response t o adverse
shocks.
0.67
0.67
1.18
1.18
We also implemented the model by using a popular spreadsheet software,
Excel, and by using widely available data. While Excel is not suitable for
all types of tax or CGE models and certainly other programs, such as
GAMS, offer greater capability and indexing ease (e.g., over sectors or
time), it is simple to use and a great way t o get started. Add-in programs
also extend its potential in new directions; for example, it is possible t o
add the element of uncertainty over critical parameters (e.g., trade
elasticities) or exogenous shocks (e.g., the collapse of an export market
like the CMEA trade) by performing risk analysis and Monte Carlo
Si mul at i ~ns. ~~
The models in this chapter present a stylized picture of how developing
economies function. They are useful for qualitative analysis. However,
policymakers are also concerned with the magnitude of the response t o their
initiatives. Furthermore, they require models that incorporate the more
distinctive structural and institutional features of their economies. The les-
sons drawn from this chapter will facilitate the interpretation of results from
more complex models, since these are essentially multisectoral analogues of
the small models developed here.
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0.67
0.67
1.18
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I
I
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8 Joseph F. Francois and Kenneth A. Reinert 1997
This book is in copyright. Subject to statutory exception
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no reproduction of any part may take place without
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First published 1997
Printed in the United States of America
Typeset in Times Roman
Library of Congress Cataloging-in-Publicario~~ Darn
Applied methods For trade policy analysis : a handbook 1 edited by
Joseph F. Francois, Kenneth A. Reinert.
p. ".
ISBN 0-521-58003-X (hardback). - ISBN 0-521-58997-5 (pbk.)
1. Commercial oolicv - Econometric models. I. Francois. J os e~h F.
. . . .
11. Reinert, Kenneth A.
HF1411.A67 1997
387.3 - dc20 96-30246
CIP
A caralog record for this book is available from
the Brirish L i b r q
ISBN 0-521-58003-X hardback
ISBN 0-521-58997-5 paperback
APPLIED METHODS
FOR TRADE POLICY ANALYSIS
A Handbook
Edited by
JOSEPH F. FRANCOIS
Erasmtrr Universiry,
World Trade Organization,
and the Cenrre for
Economic Policy Research
KENNETH A. REINERT
Kalamazoo College .
CAMBRIDGE
UNIVERSITY PRESS